Cardinal Company is considering a project that would require a $2,985,000 invest
ID: 2472110 • Letter: C
Question
Cardinal Company is considering a project that would require a $2,985,000 investment in equipment with a useful life of five years. At the end of five years, the project would terminate and the equipment would be sold for its salvage value of $400,000. The company’s discount rate is 16%.
The project would provide net operating income each year as follows:
Sales $ 2,737,000 Variable expenses 1,001,000 Contribution margin 1,736,000
Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs $ 610,000 Depreciation 517,000
Total fixed expenses 1,127,000 Net operating income $ 609,000
5. What is the project’s net present value?
6. What is the project profitability index for this project?
12. If the equipment’s salvage value was $600,000 instead of $400,000, what would be the project’s simple rate of return?
Explanation / Answer
5) Net operating Income per year = $609000
Net cash inflow = Net operating income + depreciation = $609000 + $517000 = $1126000
Note: depreciation is a non cash expense. The net profit has been arrrived at after deducting the depreciation expense. Therefore it should be added back to the net profit to arrive at the cash flow from operation.
NPV of the project
= PV of cash inflow + PV of salvage value of equipment - Initial Investment
= $1126000 x PVIFA (16%, 5) + $400000 x PVIF (16%, 5) - $2985000
= $1126000 x 3.274 + $400000 x 0.476 - $2985000
= $891924
Note: Cash flow of $1126000 is an annuity and will flow to the company for the next 5 years. hence PVIFA has been used. Whereas salvage value is received at the end off the 5th year only and therefore PVIF has been used.
12)
Simple Rate of return
= increamental net operating income from the investment /( initial investment - salvage value)
= $609000 / ($2985000 - $600000)
= 25.53%